Calculate The Company’s Weighted Average Cost Of Capital (WA

Swallowit is a small Australian pharmaceutical company. It is not fully integrated with the dividend imputation system. As at 30th June 2012, it had prepared a balance sheet with specific assets, liabilities, and equity, including details on receivables, inventories, property, plant & equipment, prepayments, accounts payable, bank overdraft, accrued revenue, debentures, preference shares, ordinary shares, reserves, and retained profits. The company pays tax at a rate of 30% and has various sources of capital with costs based on current market conditions and potential new issues. The company’s optimal capital structure appears stable over the past five years, including debt, preferred, and equity components. The overdraft is included in the weighted average cost calculations. Various expansion and investment projects are being considered, each requiring financial analysis involving net present value (NPV), internal rate of return (IRR), sensitivity analysis, and benchmarking against the marginal cost of capital (MCC).

Your task involves calculating the company's overall weighted average cost of capital (WACC), evaluating multiple investment initiatives—including constructing a new plant, acquiring distillers, and robotic equipment—by performing NPV and IRR analyses, conducting sensitivity assessments, and ranking projects based on profitability metrics. Additionally, you are to determine the company's MCC schedule, analyze project priorities within the context of this MCC, and provide investment recommendations based on the financial evaluations performed.

Calculate the Company’s Weighted Average Cost of Capital Swallowit has also asked its commercial bankers what the firm's cost of various types of capital would be, assuming that the present capital structure is maintained

Swallowit is a small Australian pharmaceutical company with a specific capital structure, assets, liabilities, and a set of ongoing projects requiring detailed financial analysis. The company’s goal is to calculate its weighted average cost of capital (WACC) accurately, considering existing debt, preferred shares, and equity, along with the costs associated with new capital issues. This calculation will inform investment decisions for projects like plant construction, equipment acquisition, and automation efforts. The analysis incorporates market data for existing and potential capital issues, costs associated with maintaining the current mix, and tax considerations. Properly estimating the WACC enables Swallowit to evaluate the viability of various projects based on their expected returns.

Paper For Above instruction

The Weighted Average Cost of Capital (WACC) is a fundamental measure that reflects a company's average cost of capital, considering the proportional contributions of debt, preferred stock, and common equity. Calculating Swallowit’s WACC requires an understanding of its current capital structure, the cost of each capital component, and the market conditions affecting new issues. This paper systematically analyzes these variables, computes the WACC, and discusses its significance in investment decision-making processes.

1. Current Capital Structure and Market Values

Swallowit's balance sheet as of June 30, 2012, indicates total shareholders' equity of $16,875,000, which is composed of preference shares ($2,000,000), ordinary shares ($10,000,000), a general reserve, and retained earnings. The total liabilities are $5,915,000, including accounts payable, bank overdraft, accrued revenue, and debentures. The market value of the company's capital can be approximated using the trading prices of its securities: preference shares at $8.10, ordinary shares at $1.75, and debentures at approximately $309.29 each.

Preference shares are perpetual, originally issued at a face value of $8.00, paying dividends of $275,000 annually. The current dividend yield and market price suggest that the dividend rate is approximately (dividends per share / price per share). Ordinary shares, with a current trading price of $1.75, total 7,500,000 shares, and dividend payments of $1,125,000, imply a dividend per share of $0.15, resulting in a dividend yield of about 8.57%. The debentures are trading at $309.29, above their face value of $300, with an annual coupon rate of 13.5%, maturing in seven years.

2. Cost of Debt

The company's current interest rate for bank overdraft is 8% annually, charged monthly. For long-term debt, the debentures' yield can be estimated using the trading price and coupon payments, or alternatively, calculated through the yield to maturity (YTM) approach. For existing debentures, the approximate YTM is obtained by solving the present value of future cash flows equal to their market price, which yields about 13.5% for the current bonds. Notably, the cost of new debt can differ: up to $1 million of new debt can be issued at 14%, and amounts above $1 million at 16%. The after-tax cost of debt is calculated as:

Cost of Debt = Yield to Maturity (YTM) × (1 - tax rate)

Given the current debt yield of 13.5%, the after-tax cost is approximately 9.45%. For new debt issues, the marginal cost increases, influencing the WACC calculation depending on the amount of new debt needed.

3. Cost of Preferred Stock

The preferred shares are trading at $8.10, with a perpetual dividend of $275,000 divided by total preferred shares outstanding ($2,000,000/1,000,000 shares), resulting in a dividend of $0.275 per share. The dividend yield is approximately 3.39%. Since preferred stock is perpetual, its cost is computed as:

Cost of Preferred = Dividends per share / Market price per share

Adjusted for flotation costs, the cost increases slightly to account for issuing costs of $0.75 per share, leading to an effective cost of preference stock of around 3.66%. However, since the current yield is more representative, we focus on the unadjusted dividend yield for simplicity.

4. Cost of Equity

The cost of equity is typically estimated using models like the Dividend Discount Model (DDM) or Capital Asset Pricing Model (CAPM). Swallowit’s dividend history over the past four years exhibits incremental growth, with dividends increasing from $0.1189 to $0.1462 per share. The average dividend growth rate (g) can be approximated as:

g ≈ [(Dividend Year 4 / Dividend Year 1)]^(1/3) - 1 ≈ (0.1462 / 0.1189)^(1/3) - 1 ≈ 8.0%

Using the DDM, the cost of equity (Ke) is:

Ke = (D1 / P0) + g = ($0.1462 / $1.75) + 8.0% ≈ 8.34% + 8.0% = 16.34%

This reflects the expected return investors require considering dividend growth and current market conditions. Alternatively, using CAPM, which considers beta and market risk premiums, would likely produce a similar estimate within this range.

5. Calculation of WACC

The percentage weights of each component are calculated based on market values:

• The market value of equity (E): 7,500,000 shares × $1.75 = $13,125,000
• The market value of preferred stock (P): $2,000,000 (initially issued at $8 each, currently trading at $8.10)
• The market value of debt (D): The market value of debentures (e.g., 4,800,000 / face value of $300, trading at $309.29), which can be calculated as:

Number of debentures outstanding = $4,800,000 / $300 ≈ 16,000 debentures

Market value of debt = 16,000 × $309.29 ≈ $4,949,440

Sum of components: $13,125,000 + $2,000,000 + $4,949,440 ≈ $20,074,440

Weight of debt (Wd) = $4,949,440 / $20,074,440 ≈ 24.68%

Weight of preferred stock (Wp) = $2,000,000 / $20,074,440 ≈ 9.96%

Weight of equity (We) = $13,125,000 / $20,074,440 ≈ 65.36%

Using the component costs:

• After-tax cost of debt: 9.45%
• Cost of preferred stock: 3.66% (approximate, considering flotation costs)
• Cost of equity: 16.34%

Thus, the WACC is calculated as:

WACC = (We × Ke) + (Wp × Kp) + (Wd × Kd)

WACC = (0.6536 × 16.34%) + (0.0996 × 3.66%) + (0.2468 × 9.45%)

WACC ≈ 10.68% + 0.36% + 2.34% ≈ 13.38%

6. Significance in Investment Decisions

The WACC represents the minimum acceptable return that Swallowit must earn on its investments to satisfy all capital providers, including debt holders, preferred shareholders, and common shareholders. A project’s expected return exceeding the WACC indicates value creation, while an return below suggests value destruction. Therefore, precise calculation of WACC is vital for assessing the feasibility of proposed initiatives—such as constructing new plants, investing in new machinery, or automating manufacturing processes—since it sets the benchmark for investment appraisal.

7. Considerations for Future Capital Raising

Swallowit’s projected costs for additional capital indicate possible increases in costs for raising further debt, preferred, or equity. For example, new debt above $1 million would cost 16%, and additional preferred stock would cost 14%, increasing the WACC if the company issues new securities. Analyzing these marginal costs helps optimize the capital structure and ensures investments are evaluated against realistic hurdle rates, aligning financing strategy with strategic growth objectives.

8. Conclusion

In conclusion, calculating Swallowit’s WACC involves integrating current market data, assessing the costs due to existing capital components, and adjusting for future issue premiums and flotation costs. The resulting approximate WACC of 13.38% serves as a critical threshold for evaluating potential investments. Accurate WACC estimates enable the company to make informed decisions on projects, ensuring they add value and align with the company's strategic financial goals.

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